BMO’s contingent risk absolute return notes linked to SPDR S&P Oil built for alpha, show risk

By Emma Trincal

New York, June 7 – Bank of Montreal plans to price 0% contingent risk absolute return notes due June 29, 2018 with digital upside linked to the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund, according to a 424B2 filing with the Securities and Exchange Commission.

If the fund finishes above the initial level, the payout at maturity will be par plus the digital return of 18%.

If the fund falls but finishes above the 60% barrier level, the payout will be par plus the absolute value of the return, up to a maximum return of $1,400 per $1,000 of notes.

Otherwise, investors will be fully exposed to any losses.

Tom Balcom, founder of 1650 Wealth Management, said that the 60% barrier was conservatively set given the recent bear market in oil prices, which has pushed down prices since their 2014 high.

“If you want to have exposure to this asset class, this is a nice way to do it. A 40% protection is pretty valuable given that this ETF has already dropped a lot. You would need a pretty severe pullback to be down 40%,” he said.

The ETF tracks the equity returns of large oil and gas exploration and production companies in the United States. It is closely correlated to the price of crude oil.

Still low

While the ETF has rallied for more than three months, buying the notes now would still make for a “good entry point,” he said.

Two years ago, the ETF share price hit a peak at $83. At about $37 a share – the closing price was $37.50 on Tuesday – the fund today is still 55% off its high. In January, the ETF fell to a $22 low but has jumped 68% from that level since then.

Because of the steep losses earlier this year, the share price is up 24% for the year, half of which occurred in the past 30 days.

Balcom explained that the digital return offers more benefits than disadvantages.

Not for big bulls

“It’s a cap, so 18% is your maximum on the upside. There is a bearish bias here because you can make twice more than that if the fund is down,” he said.

But the positive side of the upside cap is the return enhancement.

“If the fund is up a fraction of a percent, you get 18%. That’s a great way to outperform. You could miss out on the gains if there is a bull market, but I think most clients would still be happy with 9% a year.

“If a client is very bullish, don’t buy it. Just go long-only. But if you want some downside protection or the ability to make money in a down market, then this is pretty attractive. There’s got to be a trade-off, so in exchange you have to accept the possibility of losing some upside.”

Non directional

Absolute return features are popular among investors, he said.

“It’s nice to know that if the index is down 20% you make 20%. People like that.”

The combination of the sizable contingent protection and the absolute return should offset the drawback of an upside cap, he said.

This should be especially true as investors’ bullish expectations have been tempered.

“You had a correction in January and February. Clients have concerns. They’re less greedy nowadays than a year ago. These types of products with a low barrier, very defensive types of structures are a response to those concerns,” he said.

Sweet downside

Balcom said he liked the investment for the opportunity to outperform a long-only position in the fund.

The payout, however, offers a better outcome on the downside. Investors in the notes can outperform by 18% on the upside. On the downside, they can generate a 40% profit from a 40% ETF decline, which allows them to outperform the underlying ETF by 80 percentage points.

“The key element here is the amount of positive return you get from the absolute return. It’s a 40% potential versus 20% on the upside. You almost have to be more bearish,” he said.

Donald McCoy, financial adviser at Planners Financial Services, acknowledged the asymetrical returns between the upside and the downside. But he was concerned about the amplitude of the underlying price moves.

“You make money on the downside until you reach the 40% barrier, then it’s a full loss,” he said.

The risk associated with the volatility of the fund does not make the product very attractive in his view.

Cap

“I can’t say that there are a lot of moving parts with this one, but it’s not that easy to explain to a client. I guess I don’t really see why a client would take that type of risk. It doesn’t seem very enticing to me,” he said.

The first difficult part is to justify the 18% cap on an asset class that has the potential to generate that type of return in a matter of days.

“To say to a client we’re going to give up a lot of potential on the upside on something that could really run up is not impossible, but you really have to justify it and explain why they should do that,” he said.

Fat tail

This adviser had even less “faith” in the structure when looking at the downside as risk was his main issue.

“Investors in the notes are betting on volatility,” he said.

“As long as the share price stays within a range, they can make money. When it’s out of the range, it becomes very tricky. Why would you make that bet on something that moves a lot all the time?” he said.

He offered the example of the fund closing down at $41.

“You’re up 40% in the few weeks before maturity because this index is down 40%. Can you imagine sweating out looking at the chart as you get closer and closer to the end? The notes mature. All of a sudden you’ve lost 41%. There’s such a huge difference in the magnitude of returns with such a small move. A week before you were a genius. Now you’re a loser.

“You’re flipping a very large coin. The consequences are dramatic between getting it right and getting it wrong.”

Unpredictable

The historical volatility of the SPDR S&P Oil & Gas Exploration & Production ETF is 33 versus 12 for the S&P 500 index.

The greater the volatility, the greater the expected swing up or down, he explained, adding that investors are “taking” nearly three times the standard deviation of the S&P 500.

“That’s a lot!” he said.

“This thing has a huge range. It’s very difficult to predict.”

While no equity investment return can ever be predicted, it is easier to make assumptions on a less volatile reference asset, such as the S&P 500 for instance, he said.

In 2008, the SPDR S&P Oil & Gas Exploration & Production ETF lost 43% of its value. It was down 30% in 2014. The following year it dropped 35%, he noted.

“These are just annualized returns. No one can tell what this thing is going to do in a two-year window,” he said.

A decline by 40% off the current share price would bring the price to its January level at $22.

“It can certainly go back there and revisit that low,” he said.

BMO Capital Markets Corp. is the agent.

The notes will price on June 27 and settle on June 30.

The Cusip number is 06367TGA2.

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